In the summer of 2007, US financial markets found themselves in crisis. For decades, housing prices had increased steadily, making homeowners seem wealthy. Many took money out of their houses in the form of home equity loans—and spent the proceeds. Interest rates were low, and homeowners were confident they could repay the loans.

At the same time, banks and investment companies discovered they could bundle mortgages into investment vehicles. ^[8] An insatiable appetite for bundled mortgages led to aggressive mortgage marketing; mortgage companies dropped many of the standard income and asset requirements for mortgage borrowers. While the new borrowers of so-called “subprime” mortgages paid higher interest rates than standard creditworthy customers, mortgage rates were at historic lows in the mid-2000s, so the higher rates were not especially discouraging. Millions of borrowers with limited or no assets were able to buy property, essentially entirely on credit. With home prices on what many assumed was an unstoppable upward trajectory, this seemed a plausible strategy.

In late 2007 and 2008, what was belatedly recognized as a housing bubble burst, and real estate prices went into free fall. Millions of homeowners who had bought at the height of the market found the value of their houses falling below the mortgage; without the house itself as collateral, they could not refinance, could not sell, and many could no longer afford to pay their mortgages. Banks and investors in the bundled mortgage instruments lost millions. The international financial system teetered. Says Ivry:

All these defaults turned into mayhem for the financial system, because what Wall Street had done was take all these subprime loans, bundle them together and sell pieces off to investors all over the world. The theory was that the risk would be distributed, but in reality what happened was the disease wasn’t lessened by the amount of people that had it, it was made worse. ^[9]

The first public signs of trouble appeared in June 2007, when two Bear Stearns hedge funds with large holdings of subprime mortgages suffered over $9 billion in losses, and were forced into bankruptcy. At first, officials at the Fed remained sanguine; Bear Stearns was just one institution. “We are prepared to use the tools that we have to address a short-term financial crisis, should one occur,” said Federal Reserve Chairman Ben Bernanke after a Fed meeting in early August 2007.“I think the odds are that the market will stabilize.” ^[10] But over the next few days, stocks plunged as additional financial institutions reported losses tied to subprime mortgage loans. Financial institutions, concerned that mortgage-backed collateral for loans would be worthless, were afraid to lend money to each other. The system threatened to seize up.

The Fed quickly took preventive measures to ensure that banks would have enough cash. In mid-August 2007, it injected $38 billion into the US banking system to give banks the capital necessary to conduct their daily business. In September 2007, it cut the discount rate, the rate it charged banks for temporary loans; and then cut it again in December. It also created new bank lending programs, including a Term Auction Facility in December 2007 (an alternative to the discount window) and a Primary Dealer Credit Facility in March 2008.

Even as it took proactive measures, the Fed tried to calm what threatened to become a panic. In January 2008, Bernanke assured the public that the market troubles would blow over. “The Federal Reserve is not currently forecasting a recession,” he said in a speech. ^[11] A few days later, he reiterated: “[The US economy] has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself. So I think we need to keep in mind also that the economy does have inherent strengths and that those will certainly surface over a period of time.” ^[12] However, as the crisis deepened, the Fed in March 2008 changed its discount window policy, allowing banks to borrow money through the window for up to 90 days, instead of overnight—a major change.